Hidden Power of the Big Three? Passive Index Funds, Re-Concentration of Corporate Ownership, and New financial Risk†
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Business and Politics 2017; 19(2): 298–326 Jan Fichtner*, Eelke M. Heemskerk and Javier Garcia-Bernardo Hidden power of the Big Three? Passive index funds, re-concentration of corporate ownership, and new financial risk† Abstract: Since 2008, a massive shift has occurred from active toward passive investment strategies. The passive index fund industry is dominated by BlackRock, Vanguard, and State Street, which we call the “Big Three.” We compre- hensively map the ownership of the Big Three in the United States and find that together they constitute the largest shareholder in 88 percent of the S&P 500 firms. In contrast to active funds, the Big Three hold relatively illiquid and perma- nent ownership positions. This has led to opposing views on incentives and pos- sibilities to actively exert shareholder power. Some argue passive investors have little shareholder power because they cannot “exit,” while others point out this gives them stronger incentives to actively influence corporations. Through an anal- ysis of proxy vote records we find that the Big Three do utilize coordinated voting strategies and hence follow a centralized corporate governance strategy. However, they generally vote with management, except at director (re-)elections. Moreover, the Big Three may exert “hidden power” through two channels: First, via private engagements with management of invested companies; and second, because company executives could be prone to internalizing the objectives of the Big Three. We discuss how this development entails new forms of financial risk. doi:10.1017/bap.2017.6 1 The rise of passive index funds Since the outbreak of the global financial crisis, private as well as institutional investors have massively shifted capital from expensive, actively managed mutual funds to cheap, index mutual funds and exchange traded funds (ETFs), *Corresponding author, Jan Fichtner, CORPNET Project, Department of Political Science, University of Amsterdam, Amsterdam, the Netherlands, e-mail: J.r.fi[email protected] Eelke M. Heemskerk and Javier Garcia-Bernardo, CORPNET Project, Department of Political Science, University of Amsterdam, Amsterdam, the Netherlands † The authors thank Nicholas Hogan for excellent research assistance and Frank Takes for helpful comments. This research has received funding from the European Research Council (ERC) under the European Union’s Horizon 2020 research and innovation programme (grant no. 638946). © V.K. Aggarwal 2017 and published under exclusive license to Cambridge University Press. This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (http:// Downloaded fromcreativecommons.org/licenses/by/4.0/), https://www.cambridge.org/core. Ep Ipswich which Editorial permits Department unrestricted, on re-use, 22 Jul 2017 distribution, at 04:36:00 and, subject reproduction to the Cambridge in Core terms of use,any available medium, at provided https://www.cambridge.org/core/terms the original work is properly. cited. https://doi.org/10.1017/bap.2017.6 Hidden power of the Big Three? 299 which we subsume under the term passive index funds. ETFs and index mutual funds are technically different, but they share the fundamental feature that both seek to replicate existing stock indices while minimizing expense ratios.1 In contrast, active funds employ fund managers who strive to buy stocks that will outperform, which leads to higher expense ratios. Hence, we are dividing asset management into two categories—actively and passively managed funds.2 Between 2008 and 2015 investors sold holdings of actively managed equity mutual funds worth roughly U.S. $800 billion, while at the same time buying passively managed funds to the tune of approximately U.S. $1 trillion—a historically unprecedented swing in investment behavior.3 As of year-end 2015, passive index funds managed total assets invested in equities of more than U.S. $4 trillion. Crucially, this large and growing industry is dominated by just three asset management firms: BlackRock, Vanguard, and State Street. In recent years they acquired significant shareholdings in thousands of publicly listed corpora- tions both in the United States and internationally. The rise of passive index funds is leading to a marked concentration of corporate ownership in the hands of the Big Three. In 2008, Gerald Davis pointed at the historically unique situation in the United States that had emerged when a small number of active mutual funds, such as Fidelity, became large shareholders in a surprisingly high number of firms. This situation was reminiscent of the early twentieth-century system of finance capital when business was under the control of tycoons such as J.P. Morgan and J.D. Rockefeller. But contrary to this earlier phase in the development of capitalism, and despite their great potential power, the large, early twenty-first-century actively managed mutual funds eschewed active participation in corporate gover- nance. The large active funds preferred to “exit” rather than to exert direct influ- ence over corporate governance.4 Davis coined this system of concentrated ownership without control the “new finance capitalism.” The rise of the Big Three over the past decade marks a fundamental transfor- mation of the new finance capitalism. Unlike active mutual funds, the majority of passive index funds replicate existing stock indices by buying shares of the member firms of the particular index—or a representative selection of stocks in the case of 1 Braun (2015). ETFs can be bought and sold continuously the entire trading day, while index mutual funds trade only once a day after markets have closed. 2 See Deeg and Hardie (2016) for an insightful overview of different types of investors on a patient–non patient scale and a discussion on the differences between active and passive asset managers. 3 Bogle (2016). 4 Davis (2008). Downloaded from https://www.cambridge.org/core. Ep Ipswich Editorial Department, on 22 Jul 2017 at 04:36:00, subject to the Cambridge Core terms of use, available at https://www.cambridge.org/core/terms. https://doi.org/10.1017/bap.2017.6 300 Jan Fichtner, Eelke M. Heemskerk, and Javier Garcia-Bernardo indices comprising small firms that have less liquid stocks—and then hold them “forever” (unless the composition of the index changes).5 What the consequences are of the combination of concentrated ownership with passive investment strat- egies is becoming a central and contested issue. On the one hand, passive investors have little incentives to be concerned with firm-level governance performance, because they simply aim to replicate the performance of a group of firms. On the other hand, the concentration of corporate ownership may entail a re-concen- tration of corporate control, since passive asset managers have the ability to exer- cise the voting power of the shares owned by their funds. Indeed, there are indications that the Big Three are beginning to actively exert influence on the cor- porations in which they hold ownership stakes. In the words of William McNabb, Chairman and CEO of Vanguard: “In the past, some have mistakenly assumed that our predominantly passive management style suggests a passive attitude with respect to corporate governance. Nothing could be further from the truth.”6 In a similar vein, Larry Fink, founder, CEO and Chairman of BlackRock writes in a letter to all S&P 500 CEOs that he requires them to engage with the long-term pro- viders of capital, i.e., himself.7 Our aim here is to shed new light on the rise of the Big Three passive asset managers and the potential consequences for corporate governance. We present novel empirical findings, but we also identify possible channels of influence that should be the focus of future research. In other words, the purpose of this paper is both to contribute new empirics on the Big Three as well as to shape the research agenda concerning the momentous rise of passive index funds. The paper contin- ues as follows. The next section expands on theoretical discussions about owner- ship concentration in the United States and its impact on corporate control in the age of asset management. Furthermore, we discuss the pivotal shift from active to passive asset management and the sources of potential shareholder power for both types of investors. Subsequently, in section three we comprehensively map and visualize the ownership positions of the Big Three in American listed corporations. The analysis of the voting behavior of BlackRock, Vanguard, and State Street is con- ducted in section four, while section five is devoted to discussing the potential avenues of “structural” or “hidden power” by the Big Three. In section six, we high- light how passive index funds may contribute to the development of new financial risk. Finally, section seven concludes. 5 Charupat and Miu (2013). 6 The Wall Street Journal, 2015. Kirsten Grind and Joann S. Lublin, “Vanguard and BlackRock Plan to Get More Assertive With Their Investments.” Online: http://www.wsj.com/articles/vanguard- and-blackrock-plan-to-get-more-assertive-with-their-investments-1425445200. 7 Fink (2015). Downloaded from https://www.cambridge.org/core. Ep Ipswich Editorial Department, on 22 Jul 2017 at 04:36:00, subject to the Cambridge Core terms of use, available at https://www.cambridge.org/core/terms. https://doi.org/10.1017/bap.2017.6 Hidden power of the Big Three? 301 2 The age of asset management capitalism 2.1 New finance capitalism In the early 1930s, Adolf Berle and Gardiner Means famously coined the phrase of the “separation of ownership and control,” meaning that there were not anymore blocks of ownership large enough to wield effective control over U.S. publicly listed corporations.8 The dispersion of corporate ownership that Berle and Means observed empirically represented a markedly changed situation compared to the first decades of the twentieth century, when most large corporations had been owned and controlled by banks and bankers—what Rudolf Hilferding referred to as Finanzkapitalismus (finance capitalism).9 Dispersed ownership however entailed that instead of the owners, it was the managers and directors who wielded control.